Fed chief embraces improv as more predict recession

The Bear Stearns bailout and other swift steps show Bernanke's shift away from the tried-and-true.

March 16, 2008|By Edmund L. Andrews, The New York Times

WASHINGTON -- As chairman of the Federal Reserve, Ben Bernanke has long argued that a central bank should base its policies as much as possible on consistent principles rather than seat-of-the-pants judgment.

But now, as the meltdown in credit markets threatens major institutions on Wall Street and a recession appears inevitable, Bernanke is inventing policy on the fly.

"Modern monetary policymaking puts a lot of weight on rules, but there is no rule book for an economic crisis," said Douglas W. Elmendorf, a senior fellow at the Brookings Institution and a former Fed economist.

On Friday, the Federal Reserve seemed to toss out the rule book altogether when it assumed the role of white knight, temporarily bailing out Bear Stearns, one of Wall Street's biggest firms, with a short-term loan to help avoid a collapse that might send other dominoes falling.

That move came just days after the Fed announced a $200 billion lending program for investment banks and a $100 billion credit line for banks and thrifts. In a move that would have been unthinkable until recently, the central bank agreed to accept potentially risky mortgage-backed securities as collateral.

On Tuesday, the central bank is expected to reduce short-term interest rates for the sixth time since September. The Fed already has lowered its benchmark federal funds rate to 3 percent from 5.25 percent. Investors are betting it will cut the rate to just 2.25 percent Tuesday.

The mounting crisis has forced Bernanke, a former professor of economics, to discard the sanguine view of the nation's economic health that he expressed last summer. He also has abandoned his skepticism about the need to calm financial markets and set aside his concerns about the "moral hazard" of bailing out big financial institutions.

In Washington and in New York, Fed officials were expected to work through the weekend, analyzing the books of Bear Stearns and trying to prevent its troubles from setting off a chain reaction among its lenders and partners.

It was just 10 months ago that Bernanke, in discussing his reluctance to regulate the booming market for arcane credit instruments, declared: "Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or financial institution."

As recently as last summer, Wall Street executives grumbled privately that Bernanke was too disengaged from the real world, too slow to understand the plight caused by bad mortgages and too hesitant about lowering interest rates.

But Bernanke has become Wall Street's most important and most powerful friend. Executives are praising him for his creativity and willingness to act boldly. Beyond trying to lower borrowing costs by reducing the federal funds rate, the Fed has adopted a widening array of unconventional tools to infuse money into the banking system.

The questions now are whether the Fed is already too late and whether it has enough power to stabilize the markets without starting a new round of inflation. With oil and gold prices soaring to new highs and the dollar falling to new lows, investors already appear to be worrying about higher inflation.

Officially, the Fed continues to predict that the United States can narrowly escape a recession. But Bernanke has made it clear that the economy is in perilous shape, plagued by:

*A continuing plunge in the housing market.

*Rising job losses.

*Rising energy prices.

*A paralysis in credit markets as banks and financial institutions sell off even high-quality mortgage-related securities at fire-sale prices.

Most private forecasters contend that a recession is already under way, and even the dwindling numbers of optimists warn that growth will be almost stagnant for the first half of this year.